Piper Sandler Companies (PIPR) 2005 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Piper Jaffray Companies' conference call to discuss the financial results for the third quarter of 2005. During the question-and-answer session, management has asked that the media and individual shareholders remain in listen-only mode.

The Company has asked that I remind you that statements on this call that are not historically or current facts, including statements about brief (ph) and expectations are forward-looking statements that involves inherent risk and uncertainties. Factors that could cause actual results to differ materially from those anticipated are identified in the Company's reports on file with the SEC, which are available on the Company's website at www.PiperJaffray.com and on the SEC website at www.SEC.gov.

And now, I would like to turn the call over to Mr. Andrew Duff. Mr. Duff, you may begin your call.

Good morning. And thank you for joining us. I will make some comments on the quarter, and then Sandy will follow with the financial details. Let me start with a broad characterization of the quarter. We made meaningful progress. Revenues grew, and profit margin improved significantly. That said, we clearly have more work to do.

From a Capital Markets perspective, our profit margin rebounded to 18%. That's our best since becoming public in one of our strongest quarters ever. One of the drivers was our record M&A. In Q2, we highlighted our very strong second-half backlog and we realize meaningful revenues in the third quarter. We also performed well against the industry based on the number of completed deals. The industry was essentially flat year-over-year. At Piper, we were up just over 50%. Our backlog remained strong for the fourth quarter.

Equity underwriting performed on par with the industry for the quarter based on the number of completed deals. Our economic fee marketshare was up 13% in the first nine months from the full-year of 2004. The driver here is more led-managed deals as a percentage versus last year. Our equity underwriting backlog is currently 9. That's down from the second quarter, and the same as a year ago at this time.

I'm also very pleased with our initial progress of our new health-care team in London, which we announced in the second quarter. We are now listed on the London Exchange, and have commenced trading. We have initiated research on nine companies, named adviser onto cross-border M&A deals, appointed as sole financial adviser to 13 companies. As we make this investment in 2005, we expect ramping revenues in 2006.

Turning to public finance, our revenues were still solid, but down compared to two very strong quarters, that being the previous quarter this year and the third quarter of 2004. Our performance was softer this quarter versus the industry, again, based on the number of completed transactions. The industry was off 3%. We were off 25%. Through the nine months, our overall market share is down slightly.

We reported improved sales and trading results in the second quarter and again this quarter, mainly due to increased volumes in our cash equities trading business. We opened a Boston sales trading office in the second quarter which is contributing to our volume growth.

Turning to Private Client Services, our revenues were up modestly. We saw increases in both fee-based revenues and Private Client commission activity. Our profit margin improved to 61%. That's the result of both cost reductions and modest revenue increases. We clearly have much more work to do to be consistently competitive. Our adviser headcount was flat for the quarter, and we continue to balance the level of resources with a tight focus of driving our primary adviser strategy.

Finally, I comment on our cost reductions actions that were announced and implemented in the second quarter. We realized those savings in the third quarter, which contributed to our stronger results and improved margin. That was balanced by some personnel investments in our Capital Markets business, including the London team. We remain very focused on improving the profitability of Private Client Services.

Now Sandy will review the quarter in detail. Sandy?

Thanks, Andrew. First, I'll review the consolidated results for the third quarter, and then I'll provide some details on the segments.

For the third quarter, Piper Jaffray reported net revenues of 209.4 million, up 12.4% compared to the third quarter of last year and up 16.5% from the preceding quarter. We recorded net income of 15.1 million, or $0.79 per diluted share, which compared to 11 .8 million, or $0.61 per diluted share, in the third quarter of 2004 and 1.2 million, or $0.06 per diluted share, in the second quarter of this year.

These strong results were driven by increased revenues across nearly all businesses, and particularly robust M&A. In addition, we benefited from a full quarter impact of expense reductions which we implemented at the end of the second quarter.

For the quarter, non-compensation expenses were 57.1 million, up 6.8% from the year-ago period. The increase was due mainly to higher litigation-related expenses. Most other non-compensation expense categories were improved over last year due in part to cost reduction measures.

The compensation ratio for the third quarter was 61.7%, up from 61.3% last year and 61.4% in the preceding quarter. The increase in compensation ratio was due to a shift in our business mix as well as additional personnel investments made during the quarter, partly offset by our cost-saving measures.

For the third quarter, pre-tax operating margin was 11%, up from 10% for the year-ago period and up significantly from 0.9% in the second quarter of 2005, when we recognized an $8.6 million restructuring charge.

During the third quarter of 2005, the firm repurchased approximately 344,000 shares of the Company's outstanding common stock at an average price of $31.96. We are currently evaluating whether to undertake another repurchase program.

Now, I'll cover our segment results, beginning with Capital Markets. In the third quarter of 2005, Capital Markets recorded $124 million and net revenues of $22.6 million, or 22.3% from last year and up $26.4 million, or 27%, sequentially. Segment pre-tax operating income for the quarter was $22.6 million, up 43.2% from the year-ago period and up 75.8% compared to second quarter of 2005.

For the quarter, investment banking revenues were 73.4 million, up 26.3% from last year, driven by record M&A revenues. Within institutional sales and trading, net revenues of (ph) $50 million, up 17.1% from the year-ago period. The increase was mainly driven by higher revenues from interest rate products and improved equity, sales, and trading revenue due to higher trading volumes and the addition of Algorithmic and Program Trading.

Segment operating expenses for the quarter were 101.4 million, an increase of $15.8 million or 18.5% compared to last year, primarily driven by higher variable compensation expenses due to increased net revenues in profitability and personnel investments related to the Capital Markets business. Segment pre-tax operating margin for the quarter was 18.3%, an improvement from 15.6% in the year-ago period and 13.2% in the preceding quarter. The quarterly margin is the highest achieved by Capital Markets since we became a public company, and the improvements stems from higher revenues and lower non-compensation expenses, despite the additional investment in the business.

Now, I'll turn to Private Client Services. For the third quarter, this segment recorded net revenues of 87.3 million, up 2.4 million or 2.9% compared to the third quarter of 2004. Net revenues increased 3.8% compared to the second quarter of 2005. Private Client Services benefited from increased private client activity during the quarter and the continued increase in fee-based revenues, which reached another record level. For the third quarter, fee-based account revenues accounted for nearly 21% of Private Client Services net revenues, up from 18% last year.

For the three months ended September 30, segment pre-tax operating income was $5.3 million, down 25.9% from the prior year, driven by higher litigation-related expenses. Compared to the second quarter of 2005, pre-tax operating income rose 153.2% due to a modest increase in revenues and essentially flat expenses.

In the third quarter, segment operating expenses were $82 million, up 5.5% from the year-ago period. For the quarter, increased variable compensation from higher revenues was offset by savings from our restructuring actions. For the quarter, segment pre-tax operating margin was 6.1%, down from 8.4% in the third quarter of 2004, but improved from 2.5% in the preceding quarter. The margin improvement compared to the preceding quarter stems from the cost-saving measures we implemented at the end of the second quarter, coupled with a modest increase in revenues.

Lastly, Corporate Support and Other pre-tax operating loss was $3.9 million for the quarter, an increase of $700,000 over the third quarter of 2004 as higher interest rates increased interest expense on our subordinated debt.

That concludes our comments, and now, Andrew and I would be happy to take your questions.

(OPERATOR INSTRUCTIONS). Douglas Pratt, Mesa Capital Management.

Good quarter, guys. Can you talk a little bit about what exposure, if any, you may have to Refco on your derivatives side -- if you've done anything to reserve for that, or -- give us a feel for what the potential impact, if any, is to you?

We have no exposure to Refco. We had a modest trading relationship, and all of those trades have cleared and settled. We have no exposure.

Jonathan Casteleyn, Wachovia Securities.

Congratulations on the improvement. Just a couple of housekeeping items. The APT programs -- I know it runs through the institutional equity line below in the segment breakout. Where does it run through on the top corporate bucket? Is it commissions and principal transactions?

I think it primarily runs through commissions.

Okay, with that being said, can you just sort of characterize the sequential decline in principal trading? What exactly is driving that there?

Yes, there was a small decline sequentially in principal trading, and it's primarily in the Private Client sector -- less interest in private clients in fixed-income products.

Okay. So it's slackened demand for fixed income via PCG?

Right.

And you elaborated slightly on your backlogs. I think you said your underwriting backlog was 9 --?

Correct.

Can you discuss the non-filed M&A backlog? The public levels are down about 75% from Q2. Can you give us some assurance there that -- you briefly touched on your M&A backlog.

Yes, what I'd reiterate is it remains strong for the fourth quarter -- not quite as strong as the third quarter, but it does remain strong.

Okay. And can you point us -- can you peg it to some level? Can you give us a quantitative measure? How far is it down from Q2 starting levels?

The only thing I can add to that is that from a publicly announced, we've got eight.

Okay, fair enough. I appreciate that. And the cost cuts -- if I back out the restructuring cost in Q2, it looks like you cut about 2 million from non-compensation costs. That's about an $8 million run rate. I think you targeted 10 million. So I'm just wondering, where are the further -- where are the incremental costs going to come from?

Yes, just to clarify on the restructuring, it was a combination of people costs and real estate costs, with the bigger portion of that actually coming out of people costs. So I think we saw some impact this quarter from our cost reduction efforts. And you do see that reflected.

But we also did have some -- there was some normal timing fluctuation in expenses that you see from quarter to quarter. And so, I don't expect that we'll be able to achieve that going forward -- that kind of a run rate.

So I should be looking at the blended compensation and non-compensation?

Right.

As source of saves (ph)?

Right. And I think you should look at probably -- the last couple quarters on the non-comps as more of an average to kind of take some of the timing fluctuations out of that.

Okay. And that would include Q1 as well, or just Q2 in this quarter, you think?

Probably the last couple -- for the year.

Okay, fair enough. And then the compensation rate as a percentage of net revenues, you talked about some pressure there. Can you sort of drill down and give us which divisions the pricing power is coming from?

Sure. We did see a little blip in our comp ratio for the quarter, although I will just point out that year to date, our comp ratio is still down year over year. And really what drove that during the quarter were two things. First of all, we made some personnel additions in our capital markets business. And that necessarily comes slightly ahead of when we'll start to realize the revenues from those investments. And then in addition to that, we had a business mix shift where our capital market was so strong this quarter. And if you'll recall, their variable incentive plans are based on bottom-line results. So they benefit both from increased revenues as well as expense control. So the fact that we did very well on both counts for the quarter drove additional incentive compensation in our capital markets business.

Okay. So to sum it up, then, do you have more operating leverage in PCG, to the extent that those revenues start to rise? Will that hit the bottom line faster than, say, rises in Capital Markets?

We do. There's definitely a higher proportion of fixed expenses in the Private Client Group. In fact, you can see that reflected just in the change in the margin from second quarter to third quarter. We had our expenses cut. We had a slight revenue increased and had a pretty decent margin increase, despite the fact that we had a little bit higher litigation expenses.

And lastly, could you give us a TRACE update? I think there was another tranche included by the NASD. I'm just wondering exactly what you're hearing from them. And are there further tranches or securities that are going to be included? And how does that impact your business now that you've had a better chance to look at it?

We did not see additional downward pressure during the quarter on our corporate bond spreads, although as we have stated before, we expect over time there to be continued downward pressure, but we didn't see any kind of a stairstep in this quarter.

And as far as litigation issues, are things -- can you sort of quantify if they're easing off, if they're still relatively firm, or (multiple speakers).

Yes, let me just clarify. We are continuing to work through existing matters. We haven't seen a large influx of new matters. But we are continuing to work through them, and there's just a backlog of items to be worked through.

Understood.

I would reinforce that. This is the backlog that came from the bubble and the burst, unfortunately. And we're working through it and making progress.

Well, the issues are industrywide. I'm not saying they're specific to anybody.

No, I just wanted to be clear.

Douglas Pratt (ph), Mesa Capital Management.

A couple of things -- first one is kind of housekeeping. I noticed that other income was up significantly, I think, year over year -- if I've got the number right -- yes, 1.7 million last year. What comprises that whole category or the major parts of that? And why the big swing year over year? It seems like third quarter last year was kind of light.

And then secondly, could you talk a little bit about PCS? You'd focused in the last quarter about restructuring and really getting that unit moving. It seems like it's a little bit slower. Maybe talk to us about what the issues are there, and then what your outlook is for the rest of the year on that?

I'll take the first half of the question and have Andrew answer the second piece. I'm assuming, just to clarify, you were talking about other expense --

No, other income. Sorry, sorry -- you're right. I'm looking at the wrong part of the P&L. Other income -- or other expense, rather; yes.

Okay. The litigation-related expenses we referred to earlier are included in that line item on the financial statement. So we had higher litigation expenses in the current quarter. In addition, the same quarter last year, we had unusually low expenses because we had a reduction in reserve during that quarter. So it exacerbates the year-over-year change.

But -- okay, so it looks like 7.25, 7.5 has been the run rate -- no big change in that in the third quarter?

Yes, I think the third quarter was slightly higher than the last couple of quarters -- again, due to higher litigation-related expenses.

Okay.

And then I'll over to Andrew --

Yes, let me speak to the Private Client. This has clearly got our utmost focus. When we spun out of the bank a year and a half ago, we articulated that we had a three- to five-year process here to achieve a turnaround. We had been unable to recruit. We are back into recruiting -- but importantly, to really redevelop and mature our relationships with our clients to a primary adviser status. And that is a multiyear process.

And on every measure, those of our advisors who have moved into that, gone through the training, come back out, and have altered those relationships, they are making progress. And by that, I mean number of products per clients, average size of account, the pricing power that they have has increased on the assets that they manage versus those that are in a more traditional transactional and ultimately, very importantly, the growth. I would tell you at this point, we are essentially entering the halfway point in the process -- that we are making progress, but it is going to take some more time. We're very focused on it. And clearly, as a segment, this is underperforming the industry.

So I guess -- okay, I'm going to interpret that that you haven't seen the improvement you expect to get, but you think it's going to be coming because it's a longer -- you've got this longer-term plan?

I'd recharacterize that slightly. I would like to be farther along than we are. But on the three- to five-year timeline, we are actually on it. And in sort of a broad general statement, we've got about a third of our advisors into what we call primary advisory status; a third transitioning, which is about an 18-month process, where their business tends to go flat. And then the remaining third in a more traditional security selection model.

And that's pretty good progress. The financial benefits are in front of us. And you all and we all would like to see it go faster, but it's got our utmost attention.

Okay. And just a quick follow-up. What do you look at as your normalized tax rate? It bounced around quite a bit the last few quarters.

Yes, I think the current quarter and year-to-date rate are about the same, and you can expect that going forward.

So 34 -- I think it was 34.5 this quarter -- that's a good guesstimate for full year?

Yes.

Kyle McLean, KBW.

I just wanted to clarify. On the London and Boston offices, are both of those -- they're both up and running, it sounds like. And were they both contributing to revenues this quarter?

First, the Boston got up and running at the end of the second quarter, and it started to contribute some revenues. The London expansion -- we have an office there, but into domestic UK securities, that came -- virtually no revenues in the third quarter. The personnel joined us in September -- the bulk of them. And prospectively, I commented on some of the activity that's begun, but very little revenue in the third quarter. And that's going to ramp up here in the fourth quarter. But obviously, we have the full expense. And we expect a bigger benefit to be in '06.

Okay. That's helpful. And everything else has been answered except for one more clarification. The nine equity deals you said you had in the backlog -- can you break those out between IPOs, follow-on, led code (ph) -- are those all publicly filed deals or --?

They are all publicly filed. I know four of them are led-managed. I don't off the top of my head know how many are IPO and how many are follow-on.

Brian Hagler, Kennedy Capital.

Just one quick question on Private Client, and then another on I guess your backlog. I guess longer-term, going back to your three- to five-year plan, what kind of margin do you think you need to achieve to be in Private Client to be close to peer versus the 6% today?

I believe peers essentially roughly of our size get to double-digits. And we need to be there as well.

Okay.

Low- to mid-double digits.

Okay, great. And then, just real quick on the backlog, you said the nine equity deals were down from last quarter. Can you remind us what that was last quarter?

Going into the third quarter, I believe there were 14. And we, today, have nine.

Okay. And then finally, on the M&A, you mentioned the backlog was strong going into this quarter, and remained strong going into the fourth quarter. Can you give us any more detail? I don't know if you can give a number of pending deals or --

We don't. The only thing we can point to is what's been publicly filed, and there are eight. And again, I would say it's strong -- not as strong as going into the third quarter, but it remains strong.

Jonathan Casteleyn, Wachovia Securities.

I just had a follow-up question. I'm just trying to understand what you said about your primary adviser versus your transitioning status within your private client. You said a third, a third, and a third. Can you just sort of -- what does that mean -- primary adviser? Does that mean you have a certain percentage of the client's assets or are they in fee-based accounts? Because it seems like the key to your story here is unleashing that operating leverage at PCG. So I'd like a better indication of exactly what you're dealing with there.

Okay, the key metrics we use are average size of the household account, percentage of household accounts that are under 100,000, number of products -- and we think it begins to indicate a broader relationship when that gets to three or four. And then again, the yield on the assets under management by the adviser on every single one of those metrics -- those that have transitioned are performing at a higher level. It does disproportionately tend to have fee-based revenue as well. So that third is pulling up our overall average, as Sandy indicated, which is now 21%.

And a third transitioning from the security selection model? Is that what you said?

Yes, and we believe that takes approximately 18 months. There some training involved and then literally you've got to sit down with virtually every client and we establish a broader relationship. And that's quite time-consuming, but ultimately very rewarding.

You know, this is an expensive undertaking clearly. And you see it in our margin. But I have to tell you, I think it is absolutely, unconditionally what our clients want and the future of the industry. And we just have to stay the course and just get there as quickly and thoughtfully as we can.

I know your points of presence from an office standpoint. But from an asset standpoint, where are you making penetration? Where are the big pockets of your assets that you're managing now? Are they -- can you just talk about the --

You mean from a geographic basis?

Exactly.

Our biggest market share is clearly the upper Midwest. And that starts with Minneapolis/St. Paul metroplex, where we have about 21% market share, which is awfully high for a top 10 metroplex in the country. But that's -- looks something like either side of that in a 5-, 6-state region and multiple cities from Rochester, Minnesota to Fargo, North Dakota. We have a very strong franchise here, and that's the bulk of the assets.

And 5, 6 --

(multiple speakers) And what about California -- do you know California by chance?

Yes; we have a couple of offices in the Bay Area, and then two down in La Jolla.

Okay. As far as --

But our market share there would be dramatically lower.

Okay. Fair enough.

Like 1 to 2% of those very, very large markets.

So are you concentrated? Are you still looking to sort of reap gains in the Midwest, or is California -- is that an attractive place for you?

Both -- essentially, maintaining and modestly growing our share here, but we're in some very attractive markets in the west, if you will -- Denver, Seattle, Portland, San Francisco -- all with fairly large downtown offices that we think we can fill out and then maybe add one or two in the metropolitan area. Much of the infrastructure is there; it's just to build them out.

(OPERATOR INSTRUCTIONS). Douglas Pratt, Mesa Capital Management.

Could you talk a little bit about the option activity this quarter in terms of how many you granted, what the strike was on those, that sort of thing?

Yes, we actually ramp those once per year as a part of our annual bonus and incentive process -- so that the large grant typically comes in February of each year. So that next period won't be until next February of '06.

And its predominately restricted stock like 85% -- about 10 to 15% options.

And of course, that's always been expensed. So we shouldn't see any major change in that regard. Is that correct?

Correct. The only other addition we would do during the course of the year would be recruiting new personnel essentially, or some one-off situation.

Okay. And just going back for a second to the third quarter of last year. You said there was a reserve reduction which accounted for that very low other expense item. How much was the reserve reduction, and have you done any reserve reductions since then?

We don't comment about amounts of specific litigation accruals. But I think you can look at the trend over multiple quarters and see that that item was unusually low in that particular quarter. And we don't make comments on specific items.

Okay. How about -- have you done any reserve reductions since then?

No, there have not been any major changes in litigation from quarter to quarter since then.

I guess I wasn't thinking specifically about that litigation reserve, but any of your reserves. I'm just trying to determine how much of the expense reduction is an actual cash reduction, and how much merely reflected drawdown of reserves? I don't care where it was. I'm just curious -- have you done any reserve reductions?

Let me clarify. I want to make sure you're understanding what happened a year ago -- is that we obviously have outstanding litigation matters that we go through as part of each quarterly process and review what we think our potential exposure is on those items. And as a result of that process, in the third quarter of last year, we assessed that we didn't need that many reserves. And so we actually took a reduction in reserves. And that's the process we go through each quarter.

And I'm not sure if you are asking about other expense line items. We typically will explain a fluctuation if you have a question about a particular line item within expense.

No, I understand that. Just for example, the reserve reduction made expenses look less than they were last year, and therefore, pre-tax earnings higher, because obviously the reserve is a non-cash transfer. I'm just trying to determine if there was any other reserves wherever of any significants that would likewise make expenses look lower.

No.

The straightforward answer there is no.

Kyle McLean, KBW.

One more question. Can you talk a little bit about the FA headcount? It declined a little bit this quarter. And also, just give some information about the recruiting backlog and how that's coming, how many people in the classes, and so on and so forth.

Sure. The run rate of developing DFAs that we set as an objective for the year was 80 -- roughly 20 a quarter. And we are on track with that, as well as our recruiting plan for the year was, as we said, 3 to 1 -- so less than a third of that. And we are on track for that as well.

From the attrition perspective, our overall attrition rate in 2004 was about 11%, which from the information we see, was about 300 basis points under the industry. We've gotten ourselves back in a pretty good place. And our attrition at this point this year is actually running below that. So that's all adding up reasonably well.

That said, we're not gaining as much ground as we'd like, and it's quite difficult. The recruiting that's available if we were to increase our goal -- again, we're on track for it -- I think would come at noneconomic levels. The transition comp just doesn't make sense to us. So we maintain relatively modest goals, and we're getting very much the people we would like to.

(OPERATOR INSTRUCTIONS). Douglas Pratt, Mesa Capital Management.

One last question. In the second quarter Q, you commented that it looked like the -- your risk as measured by VaR had risen somewhat significantly. Has there been a significant change in the just-ended quarter? And could you talk a little bit about how you're allocating your -- I assume that that's really obviously (ph) the proprietary trading -- how you are structuring that, and what your view is to how you want to manage your VaR?

Yes, we did see a slight increase in the VaR quarter over quarter. But again, the absolute levels are pretty low relative to other firms.

We typically -- we actually are not involved in proprietary trading, just to make that clear. The VaR that you see disclosed there is related to the inventories and the positions that we hold to facilitate customer business. And necessarily, it's difficult to 100% hedge that. And so there is some inventory risk that is taken with keeping inventory on the balance sheet to meet customer flow.

Sir, we have no further questions at this time. I will now turn the call over to Mr. Duff for closing remarks.

Let me just make a couple of final comments. We're hard at work here, and continue to advance our strategic review and positioning. Our goal is to achieve primary adviser status with all of our clients, and importantly, diversify our revenues, thereby delivering more consistent performance to market cycles. We can achieve that through tight focus on our market niches, growing our product breadth and combining proprietary knowledge, advice, and products. Our top priorities remain, first of all, improving productivity and profitability in Private Client Services, and secondly, diversifying our revenues.

Thank you all for joining us this morning. Look forward to updating you next quarter.

Thank you for participating in today's teleconference. You may now disconnect.